Rising interest rates erode razor-thin margin against fiscal targets

While debt interest spending in the first eight months of the financial year has come in below the October 2024 Budget forecast, recent rises in interest rates have sparked concern (and a parliamentary urgent question for the Treasury) that the OBR will forecast higher borrowing at its next forecast at the Spring Statement scheduled for 26 March.  

The Chancellor is aiming to balance the current budget – that is, borrowing excluding investment spending – in the medium term. Despite this being the medium-term aim of chancellors for most of the last 25 years, we have in fact achieved balance only once since 2001–02 (in 2018–19, and then by the most meagre of margins: just £800 million). At the October Budget, the OBR was forecasting a current budget surplus of 0.3% of national income (around £10 billion) in the three later years of the forecast. As we commented at the time, this is a razor-thin margin and even small forecast changes might mean that further tax rises or a trimming back of planned spending would be necessary to continue to meet the target.

An increase of half a percentage point across relevant interest rates – similar to the increase seen over the last month in 10-year gilts – would, if sustained, be expected to add some 0.25% of national income to debt interest spending in four years’ time. This is around £8 billion. Unless the OBR were to revise up growth or inflation at the same time, this would reduce the margin against the fiscal target to almost nothing – and with recent growth out-turns disappointing, an upwards revision to the OBR’s growth forecast does not seem very likely. However, the issue here is not that the past month has been especially economically or fiscally eventful, but that the margin was so small to begin with.

Looking at successive OBR forecasts since 2010, around half of all new forecasts (15 out of 29) have involved a revision to the borrowing forecast of more than 0.25% of GDP due to underlying economic factors. Some of these have pushed down borrowing, but most have pushed it up.  

So the recent change is by no means unusual by recent historical standards. Indeed, at the time of the Autumn Budget, past forecasting performance suggested that the chances of the Chancellor’s headroom being eroded by this Spring were around one-in-four. This highlights the risk of governments staking their fiscal credibility on targets that are met by extremely thin margins. Under these circumstances, perfectly ordinary forecast revisions can make the difference between meeting or missing them. If continuing to meet the fiscal target requires new tax rises, or cuts to the already tight-looking spending envelope for the subsequent spending review, then the Chancellor – and we – should not be that surprised.